Financial Reporting and Financial Engineering

Let me comment first on the relationship between financial reporting and financial engineering, and then on government accounting.

For over seven decades we have worked on the assumption that writing accounting standards improves financial reporting, ignoring financial engineers who make a living out of finding ways around the written accounting standards. It may take them less than three hours to find a way around a standard that may have taken three years for standard setters to prepare. Standards affect only those who are willing to comply with them. This interplay between financial reporting and financial engineering was a fundamental issue in the creation of the financial crisis. For example, much of the securitization of sub-prime mortgages was motivated by desire to get debt off the balance sheet.

We can think of accounting in two quite different ways. One is as a satellite camera - which quietly photographs from a great distance and has no discernible effect on the images it records. The second is as a photographer paired with a model, where the model smiles and poses for the camera. We may want accounting to be like a satellite camera but it has a reflexive relationship with what it records.

There is a large gap between what standard setters can achieve and what they are expected to achieve. Social systems are so complex that it's unrealistic to expect anyone to have the knowledge and ability to design a better system. We need a better balance between the top-down imposition of standards and bottom-up evolution of accounting practice, and between dependence on rules and dependence on judgement. Over the past 70-plus years we have moved from almost total dependence on judgement to almost total dependence on written rules. The British idea of a "˜true and fair' override would help improve financial reporting.

As the crisis has moved on from banks to governments, it is worth thinking about government accounting. Just as it is difficult to stop corporate CFOs from manipulating earnings, civil servants have little power to refuse to manipulate government accounts if they are told to by the politicians. Disciplining sovereign states for poor accounting - think of Greece and its problems - is a major challenge for accounting, and it seems to be a largely unaddressed aspect of the current financial crisis.

Wall Street in Corn Fields

Derivatives in corn fields are nothing new. Futures contracts in agricultural commodities helped farmers protect themselves from variations in market prices. In March 2010, I visited Iowa State University to speak at the 25^th Anniversary celebration of its management school. A faculty friend at the university told me this story.

She was a shareholder of a biodiesel firm. It had reported a one million dollar loss on its derivative positions. She was unhappy and attended the shareholders' meeting to ask how the firm incurred the loss. She was told that the firm had hedged its inventory of biodiesel using derivatives. She asked for a more detailed explanation and accepted the offer to meet the firm's risk manager after the formal meeting ended. The twenty-something risk manager took a few shots at explaining the hedge by trying a few times, and failing, to illustrate the hedge by drawing a freehand chart on paper. Unable to explain the derivative positions the company had taken as an exercise to protect it from the risk of variations in price of biodiesel, the risk manager threw up his hands and blurted out: to tell you the truth, the guy from Goldman told me to do this. A director of the company who was kibitzing on this conversation turned to my friend and asked: are you in hedge funds?

I had thought the boiler room and bucket shop operations were made illegal and closed long ago. Deliberately chosen complexity, beyond the comprehension of their targeted customers, seems to be a common theme between those old-style scams and the new-fangled ones. ProPublica report on Magnetar, issued a week before the Securities and Exchange Commission charged Goldman Sachs with fraud, was an eye-opener for me (read or listen at http://www.propublica.org/feature/all-the-magnetar-trade-how-one-hedge-fund-helped-keep-the-housing-bubble). Are we teaching the skill, and granting degrees for it?